Looking forward into 2016, there will no doubt be further periods of volatility ahead — much like we saw in 2015. The important thing, though, is to approach the market with a positive focus on what you want to achieve for the year.
While investors need to be cautious, too much negativity can lead to missed opportunities. One way to start the year is to compile a list of stocks you’d like to own. And…be patient. You only need to look over a price chart to see how far some stocks can swing in any given year.
I haven’t yet met anybody who can regularly pick a market bottom, or a top for that matter. So, if you pick an entry price, make sure you also have an exit price before you place your trade. That is, a stop loss order.
To kick things off in 2016, I’m going to run through some of the different ways that investors can manage their trades. By manage, I’m talking about risk management. So let’s take a look at some of these different stop loss strategies now.
A review on risk management
First, a quick review on exactly what a stop loss is. A stop loss is a pre-determined point that once triggered, exits you out of a trade. You don’t sit there and mull it over. Nor is it something you debate. Once it hits that level, then you’re out.
Though normally a price level, you can also use other points, like time, or a price to earnings (P/E) ratio, for example. A stop loss helps to manage your risk by setting out the maximum you’re prepared to lose on any given trade. However, in setting your stop loss, you needs to give your trade enough ‘room’ to move.
Now let’s look at some of the more popular strategies.
One of the most common ways to set a stop loss is a straight percentage. For example, a trader might decide that they’ll put a stop loss level 10% below their entry price. If they had $2,000 allocated to a trade, then they’d exit the trade the moment it drops $200 in value.
However, you can see that 10% doesn’t give the trade much room to move. A decent correction is likely to knock you out of the trade. Determining what percentage to use often comes down to how long you plan to hold the trade for.
A long term investor (someone who might hold for seven, eight or more years) might use a wider stop. Something like 25% or 30%. Again, the idea is to give the trade enough room to move while still giving you an exit point if the trade goes against you.
One thing to note is that this percentage is not an isolated number. It needs to be used in conjunction with the amount an investor allocates to any given trade. If an investor decided they wanted to limit their risk to a fixed amount for each trade, then a volatile stock will require the stop loss to be further away than a less volatile stock. This will determine how many shares they buy.
For example, if stock A is volatile and trading at $10, a trader might decide to use a 20% stop loss level from the entry price. That’s $2 below the entry price. If they wanted to risk $1,000 per trade, then they would buy 500 shares.
That’s calculated by the risk amount ($1,000) divided by the stop loss amount ($2 — that’s 20% of $10), to give you 500 shares.
Now, if stock B is also trading at $10 but less volatile, a trader might use a 10% stop loss below the entry price. That’s $1 below the entry price. Again, if they wanted to risk $1,000 per trade, then they would buy 1,000 shares.
That’s calculated by the risk amount ($1,000) divided by the stop loss amount ($1 — that’s 10% of $10), to give you 1,000 shares.
While these are simple examples, they do show you that there’s a relationship between the number of shares you buy and the underlying volatility.
One thing you need to always be aware of is slippage. Just because you put a stop loss level at a specific price, it doesn’t mean that you’ll always be filled at that price. You need to think of a stop loss as a ‘trigger’.
Once the stop loss price is hit, it triggers your exit trade into the market. If there are no buyers at that level, then you might get filled at a lower price than what you anticipated. While there might be less chance of this happening with a big blue chip stock, it’s something you need to be aware of. Especially with smaller, more speculative stocks.
For example, let’s say an investor has a stop loss at $6.50 and the share price closes tonight at $6.60. If the market opens tomorrow at $6.40, then their stop loss is triggered. In effect, the order is now ‘live’.
However, they won’t get $6.50 because the price never traded there. Instead, it will be filled at the first available price in the market. In this example, it might be $6.40. Or, it could be lower. Your exit trade needs to be matched up with a buyer before the trade will go through.
Some brokers will allow you to limit the maximum amount of slippage you’ll accept before not placing the trade. If any doubt, give your broker a call and ask how them how their trading platform works.
A trailing stop loss is simply as the name implies. Instead of the stop loss level remaining static at the same level, it shadows the price movement of the underlying share. As the stock price moves up, so too does the stop less level.
The most common way to do this is to move your trailing stop at a fixed percentage level behind the share price. While you might start with the percentage you set your stop loss at, it doesn’t mean that you have to stick with it.
If the chart shows that the price is starting to flatten out or change direction, a trader might decide to tighten the stop loss percentage to trigger an exit. That is, to lock in a profit. For some, this can provide a clear cut way to manage their trades. It stops them from trying to guess when to get out of a trade. In effect, it takes the emotion out of the decision.
These strategies revolve around the price of the stock. But the price isn’t the only thing to use when working out your exit strategy.
Other exit strategies
Quite often an investor might find that, if a stock doesn’t go in their direction to start with, then it might not go their way at all. Perhaps the trend they bought into has lost momentum. That is, just as they buy into it, the stock starts to trade sideways.
One way to manage this is through the use of ‘time stops’. A time stop takes you out of your trade after a fixed period of time. The time frame you choose will depend on your trading strategy. For a day trader it might be as short as 30 minutes. For a trader working on a weekly time scale, it might be a single day, or they may use the open of the second day as an exit trigger.
It might be that they haven’t lost any money at all. However, there are only so many trades they can do at any one time with their account. So, they want to avoid tying their money up in a trade that isn’t going anywhere.
And of course, there is always technical analysis. It might be something as basic as a five day moving average crossing over a 30 day moving average.
As you can see, there are a multitude of different exit strategies you can use. It might be based on fundamental data — an investor might exit once a stock exceeds a certain P/E ratio. Or, if a dividend yield starts creeping up to what looks like an unsustainable level, then this could trigger an exit.
Whichever strategy you use, a stop loss is a really important tool to help you hold onto your cash when the market takes a turn for the worse.
What’s ahead for 2016
As I wrote at the start of this update, I think 2016 will throw us more volatility. In doing so, the market will also give us more opportunities to buy into quality stocks at better prices than you could in a runaway bull market.
It’s a year that will reward the patient investor.
I’m really looking forward to getting stuck into the markets in 2016. Here’s hoping that it will be a prosperous year for everyone.
Editor, Total Income
Ed Note: This is an edited extract from a Total Income update. To find out more about Total Income click here.
From the Port Phillip Publishing Library
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